Liquidity and Collateral: getting the blood to flow again

Cash is a dirty word for some cultures, but not for financial services, on the contrary. But I am not talking about the old images of the stingy bankers holding on to their $ bills or about Scrooge McDuck.

Banks, custodians, CCPs, CSDs and exchanges are the financial institutions that enable the exchange of cash for securities, the movement of cash between bank accounts, the securitization of cash, the transformation of cash into collateral. Without these markets players entire economies cannot function: they are the safe and resilient pipes and the pipe operators that enable companies to be financed, investors to invest, prices to be made, etc.

The difference between Liquidity and Collateral is that Liquidity is the money used for overnight funding during the settlement, is the money that is in the treasury of a corporate or a bank to finance short term money needs, whereas collateral is usually a security that is given as a pledge to guarantee that one has enough money for a transaction, to bear the risk of a transaction, to be able to exchange it against cash if need be in a Repo transaction, at a CCP or a broker. Collateral was historically required to be of very high quality: high grade government bonds, sovereign or agencies. However these have become extremely rare as collateral is required for many more purposes now than ever to guarantee the stability and safety of every transaction. Banks have very little of it because keeping collateral on one’s balance sheet is extremely expensive from a regulatory stand-point. But if nobody oils the pipes, they cannot work anymore. 

We have seen in our recent European Post-Trade Infrastructure Evolution: Switching Gears for the Long Run report that where collateral really needed to be optimized today was before settlement, and across assets and for listed and OTC assets. Until today this was not possible as assets were very rarely optimized between equities and fixed income, and that un-cleared derivatives, never making it to a CCP, where always excluded from cross-margining or netting opportunities offered, except after the settlement at the ICSDs but this is sometimes too late in the trade value chain.

This is changing though as Repo platforms and ICSDs have realized they needed to step in to enhance the fluidity of the financial blood. Today we are seeing a myriad of new initiatives that aim at creating some sort of “Collateral Exchange” whereby securities can be upgraded or transformed into more attractive collateral, or even exchanged against another one that is more useful at the time. Elixium with Tradition and Euroclear, Euronext’s Collateral Exchange, BoNY’s DBVX, 360T with Clearstream, the list is already long and is bound to get longer. We are excited to see how these new solutions will pan out and will be watching this space very closely. More in our two upcoming Celent reports about respectively collateral management and post trade technology.

The European post-trade landscape: regional integration initiatives paving the way for industry consolidation

The biggest changes in the global post-trade industry are taking place in Europe. The Eurosystem’s attempts to create a single market and associated market infrastructure are transforming for the European post-trade industry. Eurosystem’s Target2 Securities (T2S) project and the CSD Regulations (CSDR), along with numerous other regulations, are reshaping the European CSD (Central Securities Depositories) landscape. As settlement gets outsourced to the T2S platform, CSDs will lose a key revenue stream and will have to find new revenue by developing new offerings. Asset servicing capabilities will be a natural choice for many CSDs, but that may not be a winning proposition because they will face stiff competition from custodians, who have been offering these services for a long time. T2S will allow CSDs to expand their market coverage by becoming investor CSDs and offer domestic clients holdings of foreign securities. Efficient management of collateral has become of utmost importance, and T2S’s single liquidity pool allows CSDs to develop new collateral management solutions for their clients. EMIR requirements requiring holding of initial margin for derivative trades with a licensed securities settlement system enhance their opportunity, and most CSDs are developing collateral management solutions in response. Many CSDs are developing similar solutions to stay competitive in the post-T2S world, and there may be oversupply in the market along with duplication of efforts and investments. It is expected that the industry will go through consolidation. It is unlikely that CSDs will go out of business, at least in the short term, but their role will shrink significantly. In a new report we discuss these and several other key issues relating to the European post-trade market participants, including (I)CSDs and CCPs.

Uh Oh Moments: What’s coming next?

In line with the market’s deliberations around systemic risk, central clearing, and its subsequent impact to demand/supply dynamics around collateral assets, BIS Committee on the Global Financial System recently released a paper on Asset encumbrance, financial reform and the demand for collateral assets on 27th May. As I poured through the pages of this well-constructed report, there were a couple of “Uh Oh” moments in my head as I examined the paper’s key policy (and eventually, market) implications. Here’s what caught my eye:   1) Disclosures on asset encumbrances: “Market discipline can be enhanced by requiring banks to provide regular, standardised public disclosures on asset encumbrance… Such disclosures would include information on unencumbered assets relative to unsecured liabilities, on overcollateralisation levels, and on received collateral that can be rehypothecated… Supervisors, in turn, should receive more detailed and granular data, as required, including the amounts and types of unencumbered assets.”

Uh Oh #1: More granular regulatory reporting and requirements around the level of “free” assets on an institution’s balance sheet look to be coming. There are profound implications for how financial firms manage and inventorize the components of their assets, liabilities and shareholders’ equity at any given time (including collateral).

  2) Risk-sensitive deposit insurance: “… deposit insurance schemes could be made risk-based (e.g. through the inclusion of a dedicated risk premium in deposit guarantee pricing), taking into account the funding structure of insured institutions in normal times. The pricing could differ depending on… resolution rules.”

Uh Oh #2: “Pricing in asset encumbrance in deposit insurance schemes” seems to imply regulatory capital/RWA increases, through Basel IV or sooner through Basel III.5??

  3) Expansion in scope of stress testing: “…banks should be asked to perform regular stress tests that evaluate encumbrance levels under adverse market conditions.”

Uh Oh #3:  Expansion of dimensions to stress test – in this case, related to asset encumbrance levels, funding scenarios and collateral frameworks. Institutions need to ensure stress testing practices are sustainably repeatable and sufficiently automated.

  4) Oversight and possible regulation of the currently unregulated: “Central banks and prudential authorities need to closely monitor and oversee market responses to increased collateral demand and their effects on interconnectedness… in securities financing markets [e.g. securities lending, repo] and for shadow banking activities.”

Uh Oh #4: There seems to be an undertone that anything “unregulated” is “bad” and risky. We anticipated this trajectory in our recent “Shadow Banking Products in Europe and North America” report and highlight how different products are used, risk management implications and technology advancement opportunities that various products may represent in the coming years. What’s coming could include the possible central clearing of securities lending and repo activities, more position/exposure reporting, restrictions on re-hypothecation of assets and other forms of transparency reporting, etc.

One wonders if regulators are now stepping into the territory of choking economic activity. Do we really need to fix what is not really broken? Is transparency for transparency’s sake necessarily beneficial to the way markets operate?

  5) Extend of collateral rehypothecation permitted: “A particular aspect that has received considerable scrutiny in the policy debate on securities financing markets is the extent to which rehypothecation activities should be permitted. The recent crisis experience suggests that greater reliance on rehypothecation in financial intermediaries’ balance sheets will increase interconnectedness and make them more vulnerable to financial shocks. Rehypothecation of client assets can also delay the recovery of assets or even impose losses on beneficial owners.”

Uh Oh #5: “Interconnectness” of the financial system is a concern, but it is also inevitable given the manner capital, derivative market reforms and collateralization rules are implemented. Instead of working to stop this interconnectedness from happening, regulators could do well to put in place “in-time circuit breakers” in the financial system to only “trip” when stress scenarios and adverse market conditions bubble up (pardon the pun).

  Whilst the above points remain “thinking points” and nothing is concrete, it does provide us with a possible glimpse of what is coming. If we think that regulatory burdens in the financial industry are onerous now, regulators are only getting started! Keep your strategy nimble and technology sufficiently flexible – built not just for current requirements, but for future changes. These changes may come sooner than you think! ————– For more detailed perspectives, please see the following: Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies Shadow Banking Products in Europe and North America Equipping the Front Office for the New Risk Environment Cracking the Trillion Dollar Collateral Optimization Question Strength Under Fire in Risk Management

Cash safe haven for investors and corporates?

I was writing a piece of research on the ABS and Repo markets in Europe this Summer and stumbled onto an innovative product offered by MTS and Newedge, Agency Cash Management (ACM) and thought, “wow, this is really innovative and this is what the market needs”. ACM does provide a tri-partite Repo system whereby investors, in an electronic auction regulated platform, enter into a repo trade with banks via tri-partite agents, exchanging their extra cash against good collateral, lending securely and concurrently earning a fee for it. This is really spot on to me as many investors nowadays have extra cash that they do not know where to invest, that they do not want to leave on a bank deposit account because they don’t trust their bank’s creditworthiness anymore, or that they do not want to invest in a Money Market Mutual Fund because they got burnt during the crisis. However they do want to get some return for lending that cash to someone. ACM does exactly that. This is theory obviously, in practice going after all the potentially cash-rich investors, getting them to sign tri-partite contracts with tri-partite agents is going to take some time. Also, in the good quality collateral constrained environment that we are in, banks may not have all this good collateral to offer against these piles of cash, but then again they may find a way to transform bad collateral in good one, this is what banks (and shadow banks and shadow banking products) excel at doing. EurexRepo and Eurex Clearing are working on a similar offering to ACM that should launch in 4Q2012. The model is created to offer banks that are current GC Pooling clients a facility to enter into a Repo trade with their coporate clients, in an electronic and centrally cleared environment. Cleastream is the tri-partite agent here and can take care of the collateral management, which is becoming ever more useful. Practically it may be as hard to get corporates as to get investors to sign tri-partite repo agent contracts, but the theory holds: cash-rich corporates, like investors, do not want to leave their cash on a deposit account, want a secured way to place their cash and want a fee for it. We see both as really innovative products that respond to real market needs: watch this space.

Where is all the collateral going to come from?

As we move towards a scenario in which central clearing of standardized OTC derivatives becomes the norm in markets across the globe, there is one question that is on the lips of a number of practitioners in these markets. And that is, “where is all this collateral going to come from?”. The collateral and margin requirements across the various markets mean that there would be a requirement for vast amounts of (relatively) good quality collateral. The OTC market is many times the size of its exchange-traded counterpart, hence we are talking about a gigantic exercise involving trillions of dollars. What makes things worse is that the clearing houses and CCPs are not expected to provide much interest on the collateral provided to them. In effect, we are looking at a situation in which funds and securities that might otherwise have been used for trading will go out of the system. In a recent event that this author attended, the consensus was that the volumes traded in not just the OTC derivatives market but also other asset classes such as fixed income would dip sharply. It would become quite difficult for the market participants, especially the smaller firms, to sustain themselves in such an environment. Our hope is that in enforcing these changes we do not throw the baby out with the bath water.